The Fed takes action

Market analysis
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12/16/2016

With economic data suggesting some acceleration, market sentiment was dominated by central banks. Mario Draghi had to clarify ECB strategy following a number of ambiguous comments from monetary policy committee members. The ECB is not looking to tighten and even offered some forward guidance.

It was a different situation in the US where doubts over Fed intentions resurfaced. The 25bp rate hike was fully expected and there was nothing surprising in the official communique which remained committed to a very gradual pace of further rises. But there was a strong market reaction to the rising dot picture which plots the interest rate expectations of FOMC members. Yields on US Treasuries and the US dollar both rose sharply. But there are grounds to play down these expectations:

- Janet Yellen did so during her press conference.

- If we exclude dots at the extreme highs and lows, and only look at the average score, interest rate expectations up to 2018 have actually been revised lower. And an ‘extreme laxist’ like James Bullard, who had previously voted against raising rates, now thinks that a final 25bp rise will be necessary by 2019. Should markets worry about these developments? Probably not.

- The dot plot has previously been a poor indicator on interest rate trends and not a very manageable communication tool.

In short, worries over the Fed’s reactions have become exaggerated. Nevertheless, the Fed is facing the same uncertainties as investors over gauging future fiscal policy. We should only start to worry if a genuine economic stimulus policy were to be introduced.

European equities

European equities pushed higher against a backdrop of persistently accommodating monetary policy and the Fed's decision to raise its benchmark rate. Stocks like banks, which are likely to benefit from the Fed's move, continued to trend higher. But it was the energy sector which led rises following the previous weekend's agreement between OPEC countries and other to cut output. The news sent oil prices up to a 17-month high.

In the autos sector, Beijing is considering increasing taxation on small vehicles to 7.5% from 5% but the move has already been discounted by markets. In Europe, new registrations rose 5.6% in November with Renault, BMW and Daimler posting double digit growth. Michelin also had a good November, especially in Europe. Elsewhere, Metro’s full year figures were in line and the group made a convincing case for spinning off its food and electronic businesses. H&M posted a disappointing 9% rise in sales in November; consensus expectations were for +13%. Zodiac’s first quarter sales slipped 2.8% when expectations were for a 2% increase.

It was another busy week for M&A. Amundi paid EUR 3.54 for Pioneer and said it sees EUR 150m in cost synergies and EUR 30m in revenues. Actelion remained in talks with bidders. Johnson & Johnson has walked away but Sanofi is reportedly interested. Vivendi said it had bought 12.32% of Mediaset and intended to continue buying. M6 is to spend EUR 216m M€ for the RTL Group’s radios (RTL, Fun and RTL2), a deal which makes strategic and financial sense. Fox is bidding GBP 10.75 a share for Sky, a 36% premium on the last close.

US equities

In a relatively quiet week, the S&P edged higher but nevertheless hit new intraday highs. As expected, the Fed raised its rates. Janet Yellen said the jobs market was healthy and in no need of fiscal stimulus. She added that the US economy is strong and will continue to improve so the Fed will be able to raise rates further in 2017. And she also pointed out that inflation was running in line with the 2% target and that she was quite happy with equity market levels. The Fed is now planning 3 rate rises next year.

Elsewhere, November retail sales rose 0.1% compared to October while industrial production fell 0.4%. November CPI (less meaningful a measure than the PCE) remained around 1.7%.

Yields on 10-year Treasuries stabilised at 2.5%, providing some relief to defensives which enjoyed the biggest weekly advances. Healthcare, telecoms, consumer staples and utilities all rose by more than 1.5% while financials and cyclicals fell back.

Japanese equities

The Nikkei 225 index rose for an eighth straight session, revisiting a year high and the Topix ended the week 2% higher as the yen weakened against US dollar (-3.7%) and the euro (-1.1%). At the beginning of the week, equities continued to rise as the yen weakened to around 115 against US dollar. After a slight fallback, share prices climbed again as the yen fell further following the Fed’s rate hike and expectations for further hikes at a faster pace than expected.

Otsuka Holdings, the main shareholder of Otsuka Pharmaceutical, soared 9.3% after Takara Bio announced that it had signed a license giving Otsuka Pharmaceutical exclusive rights on developing and marketing the oncolytic virus HF10.

In contrast, SMC (pneumatic equipment) dived 11.6% after a strong sell recommendation from Well Investments which criticized the company’s inappropriate accounting procedures. The company denied the allegation.

Emerging markets

The emerging market implications of the Fed’s shift were immediately visible mid-week in declines spanning from South Korea’s won to India’s rupee. The People’s Bank of China let the renminbi hit its lowest since 2008 versus the US dollar. The dollar’s surge triggered the biggest selloff for emerging market nation peers since Donald Trump’s presidential victory.

China’s economic stabilisation held up well in November. Online sales, as well as home furnishings for newly completed homes, saw especially strong growth. With the economy just out of deflation, and the recovery still shaky, support from the government is expected to remain in place until the upturn becomes more broad-based. The country’s total social financing, almost double the amount reached in October, rose to RMB 1.74 trillion (EUR 240bn) in November. New renminbi loans were strong with high demand for mortgages and short term loans from small and medium sized enterprises. While this should underpin activity in the short term, it does add to concerns over the already high level of Chinese debt, particularly among private companies.

Tencent, China’s internet giant, edged lower after solid third quarter results. One point of worry was the rising content cost in its video segment. Competitors, like iQiyi and Yoku, are proving aggressive in securing exclusive content. Tencent admits that there is no timeline for the breakeven point on video content but in our view this is not critical as other new segments are growing fast. Its cloud and mobile payments divisions, Tenpay and Wechat payment, are enjoying higher revenues and margins. Gross margins are running at 18% and they have lots of room for improvement to eventually reach the group’s 40% average.

Indonesia’s central bank kept its benchmark interest rate unchanged for a second month as the US interest rate hike added to the risk of increasing capital outflows from emerging markets. The central bank held the seven-day reverse repurchase rate at 4.75 %.

The same risks, along with political risk over parliament’s vote to impeach President Park Geun-hye, also moved South Korea’s central bank to leave its benchmark interest rates unchanged.

In Brazil, the senate approved the cap on government spending for the next 20 years. The next trigger for the economy will be the acceleration of interest rate cuts and pension reform.

Commodities

Following the November 30 OPEC agreement, non OPEC countries confirmed they would be participating in the 558,000 b/d reduction. All now seems set for a decline in oil inventories. We can still query the effectiveness of non-OPEC cuts as Russia, which has agreed to a 300,000b/d reduction, has a poor track record and most of the other countries have declining oil production. Mexico for example, is “participating" for 100,000 b/d. In addition, unlike the OPEC agreement, no production reference has been set for non-OPEC countries. Saudi Arabia, however, offered some reassurance by saying it intended to cut output to significantly lower levels than those agreed.

In its monthly report, the IEA now sees a supply deficit as early as the first half of 2017. These relatively optimistic estimates are based on strong demand growth (+1.37 million b/d in 2016 and +1.32 million in 2017) in the US, China and Europe as well as on reduced supply due to the recent agreement to reduce production. Pending some hard facts on production at the end of January, oil has stabilised at USD 54 for Brent crude and USD 51 for WTI. This week’s rise in the US dollar had no impact but US oil output data could introduce some downward pressure in coming weeks. The low in US production has been reached and there are increasingly indications of a resumption in drilling.

As expected, the Fed raised its rates by 25bp but now sees 3 further hikes in 2017 rather than 2 as previously indicated. This has reinforced the US dollar to a 14-year high against the euro and is obviously bad for gold prices. The ounce reacted by falling back below USD 1,150, a level not seen since the end of January 2016. There have been steady ETF outflows (-9% since the high on the eve of the US presidential elections) but no panic selling. Reflationary prospects should, however, limit the downside.

Corporate debt

Credit

As expected, the Fed raised its benchmark interest rate by 25bp but surprised investors by adopting a more hawkish outlook. Due to the pace of economic growth and expectations inflation will revive, it now expects to raise rates another 3 times in 2017 rather than twice as indicated three months ago. This more aggressive stance appears to have been prompted by Donald Trump’s stimulus programme, mounting signs of inflationary pressure and rising inflation expectations, especially following OPEC’s recent agreement to cut production levels.

As a result, long duration bonds underperformed while credit indices flirted with their year lows. The Xover ended at 295bp (down 6bp on the week and close to the April 21 low of 291bp) while the Main was at73bp (stable over the week compared to the September 7 low of 65bp).

In M&A news, Bloomberg reported that talks between Sanofi and Actelion were at an advanced stage. Sanofi is apparently bidding USD 285 a share, valuing the Swiss biopharmaceutical company at USD 29.6bn (EUR 28.4bn).The price tag represents a 40% premium on the last close. Elsewhere, the battle to acquire Lavendon continued. Loxam has once again sweetened its bid to 250p, valuing the company at GBP 425m (EUR 500m). The move occurred after TVH had raised its bid to 230p. Loxam’s new bid values Lavendon at 6.2 times EBITDA.

In Italy, Monte dei Paschi announced a EUR 5bn rights issue which it hopes to complete by December 31 at the latest. There were also reports that the Italian government would be ready to inject EUR 15bn in the bank or in other struggling banks.

Convertibles

With the Fed in more hawkish mood, the primary market is now ready to rumble. World Wrestling Entertainment strengthened the US convertible universe with an upsized USD 200m 7y maturity at 3.375%. This was followed by a second convertible for Aegean Marine Petroleum (Shipping) - USD 150m at 4.25% due 2021 - and USD 225m at 3% due 2023 for Amicus Therapeutics (a biopharma specialised in genetic diseases). Finisar (Fibre optic & network) offered USD 450m over 20 years with a coupon between 0.25% and 0.5% - pricing was to be announced.

Japan’s new issues market is also taking off. Mirait Holdings (telecommunication engineering company) issued a JPY 16.5bn 5Y zero coupon, the first issue from Japan since September. Given the Nikkei’s levels, we expect more issuance in the coming months.

On the earnings front, Metro announced strong full-year results with divisional EBIT ahead of consensus by 13%. The company also presented its plan to spin off its wholesale& food company Metro AG and consumer electronics company Ceconomy with current shareholders getting one share of each new entity. Nyrstar welcomed a new CEO and announced another sale of a mine in Peru and mineral claims to Glencore for USD 26m. Outokumpu continued its impressive YTD rally as ferrochrome prices settled 50% higher QoQ; as an integrated stainless steel producer and the only European operator to have its own chrome mine, Outokumpu’s earnings are sensitive to ferrochrome price changes.

In M&A, Steinhoff and Shoprite announced a merger of their African retail businesses with Steinhoff receiving new Shoprite shares in exchange for the assets. The valuation of the assets and the swap ratio have not yet been announced. Steinhoff shares fell 6% on the news. In the US, Yahoo tumbled 6% as Verizon said it was mulling whether to scrap its planned acquisition because of the scandal over 1 billion accounts being hacked.